The chiefs of central banks are a haughty, self-assured lot who will not brook outsiders’ interference in their affairs. Preserving autonomy was one of the central tenets of financial reforms. Their reputation was fortified by the record of Paul Volcker, the legendary chair of the US Federal Reserve, who fought and tamed raging inflation. Volcker is a role model for embattled Fed chiefs.
No wonder current chair Jerome Powell wants to be regarded as the second coming of Paul Volcker. (Think of Powell as Volcker’s wannabe second coming, John Authors, Bloomberg, September 21, 2022). Sadly, for Powell, the present circumstances are different.
After the early eighties, when Volcker had slain the inflation ghost, three decades of financial stability followed. Those were also the years marked by financialisation, the spread of multinational corporations, and the Southern tilt of the global economy, especially the rise of China.
Globalisation ordained by the WTO, IMF, WB, etc., tended to benefit the advanced western countries more than the emerging economies. Price stability across the globe was one of the unstated benefits. Not only were the southern supplies, mostly consumer goods, cheap, but they also helped to fill “output” gaps.
Surprisingly, all the credit for bringing out price stability was laid at the doors of monetary policy tools based on “neo-liberal” economics and its offshoot “the efficient market hypothesis”.
They advocated the need for an independent central bank unfettered by others. The central banks, in turn, were clutching at their tools, viz. interest rate and liquidity, as immutable magic wands to tame inflation. They built around these concepts sophisticated models based on algorithms. Indeed, monetary policy had become exotic but lost touch with reality.
The great financial crisis of 2008 further exposed the failure and the inefficacy of the tools at their command. A sound monetary policy requires a deeper understanding of financial markets.
As Prof. Joseph Stiglitz, Nobel Laureate, explained in his C D Deshmukh lecture delivered at the Reserve Bank of India, “Most of the propositions that have been at the centre of the monetary policy for the past quarter of a century need to be rethought.”
In our earlier column, The dragon at the doors of the US (November 26, 2021), we wondered whether “he (Powell) could steer the central bank in choppy waters”. He believed inflation was “transient” and faded in the early days. Later, he did refer to the problems created by supply bottlenecks. By summer, there was the hope of an easier monetary policy or what was described as “Fed pivot”. It did not come about. However, the Federal Open Market Committee (FOMC) announced an increase of 75 basis points and more increases to follow. At the Jackson Hole Economic Symposium held in August this year, Powell affirmed he would “keep at it”, referring to rate increases. As Bloomberg said, those words were borrowed from Volcker.
Interestingly, at the Symposium itself, opinion was highly divided. As Financial Times reported, “Central bankers face a more challenging economic landscape than they have experienced in decades and will find it harder to root out high inflation…” (Global economy faces the greatest challenge in decades, policymakers warn, August 29, 2021).
Normally, the annual Jackson Hole symposia are occasions for self-congratulation by central bankers. This time around, it was marked by gloomy and confused forebodings. We can’t blame them. This time around, inflation had several bafflingly interconnected roots.
If it was unfortunate that the Covid-19 epidemic preceded inflation, it was equally, if not more, unfortunate that the invasion of Ukraine by Russia followed it. The US sanctions on Russia were the last nails on globalisation. What many analysts fail to reckon with are the policies of President Trump to decouple the US from China and the relentless “trade war” that he waged. Trump might have weakened China in some respects, but in the process, he weakened his own country in several ways. Many current inflationary surges could be traced to Trump’s adventurist policies vis-à-vis China. He had underestimated the resilience of China, even as he underestimated the US’ own dependence on China, especially the supply chains for high-tech components.
There were several shocks from the supply and demand sides. The peculiarity of the Covid-19 pandemic was that both supply and demand shrank, a phenomenon not witnessed historically.
When inflation reared its head, it baffled policymakers, particularly the Fed. Researchers attributed it to the income support given to combat the epidemic. Later, attention shifted to bottlenecks, shipment delays, port congestion, etc. A research paper by the Richmond Federal Reserve covers the issues very well. (Supply Chain Disruptions, Inflation, and the Fed, John Mullin, Federal Reserve Bank of Richmond, Third Quarter 2022).
The critical role played by supply chains was not grasped in the early months of the surge. Those chains were set up mainly in China by MNCs. A large value supply of components was ensured with all the assurance of quality, delivery, etc. These structures came under attack by Trump. In due course, the adverse impact came to the fore and affected the supply of critical components, especially in microelectronics such as chips. Chips are embedded in most manufacturing ranging from automobiles to aeronautics to spacecraft. There is a scramble for chip fabrication. It may take many years before they begin their supplies. Surely, the price will be higher, and the flexibility of supply chains will be lost for good. This is an aspect of deglobalisation and as Rana Foroohar puts it, “A deglobalising world will be an inflationary one.” When Volcker applied the rate ferociously, he didn’t have to face these issues, and all the companies were US-based.
There are three issues which limit Powell’s ability to raise interest rates:
1. The hardening of the dollar rate depreciates most currencies, which could destabilise the markets and developing countries.
2. The global debt hag and excessive interest rates could lead to defaults and/or bankruptcy.
3. It would lead to a recession and take years to recover.
Jerome Powell cannot imitate Paul Volcker. This time it is different.
Kandaswami Subramanian served in the Ministry of Finance, GOI, and retired as Joint Secretary. He can be reached at subrabhama@gmail.com